REIT Focus: Realty Income Corporation

by: Joseph Ori, CFA

Summary

O is a net lease REIT that owns 4,703 net lease properties with 80.5 million sq. ft. and located in 49 states and Puerto Rico. The portfolio is 98.3% leased.

O is a well managed REIT with a diversified portfolio of net lease assets. O has low leverage at 27% of enterprise value and an attractive dividend yield of 4.46%.

Although we like O, we are not recommending purchase of the stock at the elevated price of $55/sh. We would be a buyer of the stock in the mid $40's.

O is subject to higher interest rate risk than a REIT that owns commercial properties with varied tenants and leases. This is because net leases are bond like investments.

This REIT Focus is on Realty Income Corporation ("O"), a publicly traded REIT that is engaged in the business of generating dependable monthly cash dividends from a consistent and predictable level of cash flow from a portfolio of net lease properties. O owns 4,703 net lease properties with 80.5 million rentable sq. ft.

Property Information

O's net lease properties are located in 49 states and Puerto Rico. As of Q3-16, portfolio occupancy was 98.3% and the weighted average lease term was 9.8 years. The largest tenants in O's portfolio are; Walgreens Corporation (204 properties and 7.3% of rental revenue), Federal Express (43 properties and 5.7% of rental revenue), Dollar General (524 properties and 4.3% of rental revenue) and LA Fitness (47 properties and 4.0% of rental revenue). Same store rent growth for Q3-16 YoY was 1.1%.

Major Events

· In October 2016, O issued $600 million of 3.0% senior unsecured notes due 2027 with net proceeds of approximately $587.2 million and used to repay borrowings outstanding under its credit facility.

Corporate Data

O is incorporated in Maryland, went public in 1994 and is traded on the NYSE. O is based in San Diego, CA and its debt is rated Baa1 by Moody's, BBB+ by Standard & Poor's and BBB+ by Fitch Ratings. O has a market capitalization of approximately $14.470 billion.

Management

John P. Case, 52, CEO

"Mr. Case was promoted to Chief Executive Officer in September 2013. He joined Realty Income in 2010 as Executive Vice President, Chief Investment Officer and served in this capacity until March 2013, when he was promoted to President, Chief Investment Officer. Prior to joining Realty Income, Mr. Case served for 19 years as a New York-based real

estate investment banker. Most recently, he served as the co-head of Real Estate Investment Banking for RBC Capital Markets, where he also served on the firm's Global Investment Banking Management Committee. Prior to joining RBC, he was co-head of America's Real Estate Investment Banking at UBS. During Mr. Case's career, he was responsible for more than $100 billion in real estate capital markets and advisory transactions. In addition, he is extensively involved in the broader real estate industry, serving on the National Association of Real Estate Investment Trusts (NAREIT) Board of Governors and as a member of The President's Council of the Real Estate Roundtable and the International Council of Shopping Centers (ICSC). Mr. Case graduated from Washington and Lee University, with a Bachelor of Arts degree in Economics, and the Darden School of Business at the University of Virginia, with a Master's in Business Administration."

Summit Roy, 46, President and COO

"Mr. Roy was promoted to President in November 2015 and Chief Operating Officer in October 2014. He joined Realty Income in 2011 and was promoted to Chief Investment Officer in 2013. Prior to joining the company, Mr. Roy served as Executive Director for UBS Investment Bank where he worked for 7 years. During his tenure at UBS, he was responsible for more than $57 billion in real estate capital markets and advisory transactions. Prior to joining UBS, he worked at MeadWestvaco, Merrill Lynch, and as a Principal at Cap Gemini. Mr. Roy has a Bachelors and Master's degree in Computer Science. He also holds a Master's in Business Administration in Finance and Economics from the University of Chicago, Booth School of Business."

Paul M. Meurer, 50, EVP, CFO and Treasurer

"Before joining Realty Income in 2001, Mr. Meurer spent 14 years working as an investment banker for both Goldman Sachs and Merrill Lynch. His investment banking career was focused on capital markets and advisory transactions for public and private real estate companies, including several REIT IPOs. He was Realty Income's investment banking advisor during the initial listing of the company on the New York Stock Exchange in 1994, and then was deeply involved in the company's early growth and public capital markets strategy, participating in all the company's capital raising transactions, before joining the company as Chief Financial Officer in 2001. Mr. Meurer has a Bachelor of Science degree in Finance and Management from The University of Virginia, and a Masters of Business Administration degree from Stanford Business School."

(All biographic information per O.)

Ownership

Top Institutional Holders:

Shares

%

The Vanguard Group, Inc.

42,640,000

16.49

State Street Corporation

15,578,000

6.02

Invesco, Ltd.

11,994,000

4.64

Blackrock Fund Advisors

9,763,000

3.78

Blackrock Institutional Trust Co.

8,978,000

3.47

Click to enlarge

Ownership Breakdown

% of Shares Held by All Insiders and 5% Owners

.34%

% of Shares Held by Institutional & Mutual Fund Owners

64.8%

Number of Institutions Holding Shares

551

Click to enlarge

All amounts above per Yahoo Finance

Financial Analysis and Valuation

Select financial data for O as of the Q3-16 10Q and supplemental information

(in millions where applicable):

Click to enlarge

Financial Data

Amounts

Real Estate Assets, Gross

$13,152

Total Assets

$12,536

Property Debt (at a weighted average interest rate of approximately 4.1%)

$5,250

Common Stockholders' Equity

$6,754

Revenue

$815

Net Income

$202

Net Income Per Share

$.80

Cash Flow from Operations

$579

Unsecured Revolving Credit Facility ($2 billion with $1.08 billion used)

$918

Market Capitalization

$14,470

Property Debt to:

Gross Real Estate Assets

40%

Market Capitalization

36%

Enterprise Value

27%

Dividend and Yield ($2.42/sh.)

4.46%

Click to enlarge

Valuation Methodology

Q3-16 Real Estate Revenue

$277

Less: Q3-16 Real Estate Operating Expenses (excluding depreciation, amortization, interest expense and plus G&A expenses)

31

Q3-16 Net Operating Income

$246

Projected Inflation Rate at 3.5%

x1.035

Projected Q3-16 NOI

$255

Projected Forward Annualized NOI

$1,020

Projected Average Cap Rate

6%

Projected Value of Real Estate Assets

$17,000

Add: Net Operating Working Capital (at book value)

760

Total Projected Asset Value of Company

$17,760

Less: Total Debt Per Above

(5,250)

Preferred Stock (at liquidation value of $25/share)

(408)

Projected Net Asset Value of the Company

$12,102

Common Shares Outstanding-258.6M Common Shares

Projected NAV Per Share

47

Market Price Per Share on 11/15/16

55

Premium (Discount) to NAV

17%

Click to enlarge

Financial Metrics

The gross real estate assets, property debt, revenues, net income, funds from operations, return on invested capital and dividends per share for the years 2011 through Q3-16 are shown in the table below:

(millions except per sh. amounts) amounts)

2011

2012

2013

2014

2015

Q3-16

Q3 2015 2015

Gross Real Estate Assets

$4,971

$5,920

$9,899

$11,153

$12,296

$13,152

Property Debt

$2,054

$2,883

$4,166

$4,930

$4,840

$5,250

Revenues

$410

$475

$780

$933

$1,023

$815

Net Income

$132

$114

$203

$227

$256

$202

Funds from Operations (FFO)

$249

$260

$462

$562

$652

$535

Return on Invested Capital (1)

9.4%

8.5%

7.3%

8.0%

8.1%

NA

Dividends Paid Per Share

$1.75

$1.82

$2.19

$2.20

$2.29

$2.20(2)

Click to enlarge

(1) This is the ratio of cash provided by operations plus interest expense divided by stockholder's equity plus property debt, less cash and measures the return the REIT is earning on its invested capital.

(2) Dividend is currently $.202 per month.

The total return of O year to date and through five years is show in the chart below per NAREIT:

O Total Return

YTD (10/16)

1-Yr

3-yr

5-Yr

18.48%

24.81%

17.76%

17.48%

Click to enlarge

As shown above, our net asset value per share for O is $47/sh., compared to a market price of $55/sh. Current average cap rates for net lease properties per our industry

experience and CBRE's Cap Rate Survey are in the 4% to 8% range, depending on the lease terms, tenancy and credit quality of the tenant. We have used an average cap rate of 6% due to O's portfolio being large and well diversified by property type, geography and tenant.

Valuation Analysis

O's strengths, concerns and recommendations are as follows:

Strengths:

· Diversified portfolio of net lease properties.

· Investment grade credit rating.

· Low leverage at 27% of enterprise value.

· Experienced management team.

· Attractive dividend yield of 4.46%.

· High return on invested capital.

· Gross real estate assets have grown 164% since 2011.

Concerns:

· Dividend has only increased by 38% since 2011, while gross assets have grown 164%.

· Elevated stock price at $55/sh and FFO multiple of 20x.

· Stock price volatility due to projected interest rate increases.

Recommendations:

O has a solid and diversified portfolio of net lease properties and our recommendations are as follows:

  • We like O due to its diversified portfolio of net lease asset, however, we are not recommending the purchase of the stock at the current elevated price. We are a buyer of the stock in the mid $40's.
  • O should further increase its dividend. The cash flow from operations for Q3-16 was $579 million and the total common and preferred dividend payment was $473 million or a difference of $106 million, which provides ample cash for an increased payout.
  • Investing in net lease real estate assets is a bond spread game, by buying net lease assets at cap rates from 6.5% to 7.5% and financing them at 4.5%, thereby earning the spread. The leases are like long term bonds, with the duration of O's leases at 9.8 years, and they have small annual rent increases. Since net lease REITs own bond like leases, they are subject to greater interest rate risk. If rates continue to increase (the 10Y-Tnote has risen from 1.75% to 2.2% in the last 90 days), net lease REITs will see their stock prices decline more than a standard commercial multi-property and lease REIT.

A five-year price chart of O is shown below.

Click to enlarge

Disclosure: I am/we are long VARIOUS REITS IN AN ETF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.